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Bankers Trust Pays $67 Million to Settle Derivatives Dispute With Chemical Firm"

Background

"Bankers Trust New York Corp. said it settled a derivatives-related dispute with a chemical company for $67 million, the largest sum the bank has paid so far to a disgruntled derivatives client." (WSJ, 1/25/96, p. I)

 

1. "Bankers Trust has been fighting accusations for over a year that it has used misleading sales tactics to sell risky derivatives contracts to a number of corporate clients. Bankers Trust some analysts said the settlement, involving Air Products & Chemicals Inc. of Allentown, Pa., is a significant step toward resolving all outstanding claims against the bank." (emphasis added)

 

a. What are derivatives?

Derivatives are contracts whose value depends on some underlying asset, such as bonds, stocks or commodities.

 

b. What is their economic function?

The economic rationale for using derivatives is to reduce risk. Companies use them to cushion the impact of unforeseen changes in interest rates, stock market fluctuations or foreign exchange on their cash-flows. However, just like any other financial security, they have been used for pure speculation by some investors.

 

c. Who is to blame for derivative related disputes?

In general, both sides of the dispute can be partially blamed. The sellers of these contracts are commercial or investment banks, and the buyers are companies. It can be argued that a number of the sellers have tried hard to push their sales on companies. On the other hand, a large number of the buyers are not sophisticated enough to understand how these instruments work or the risk involved. It should be noted that they are extremely complicated even for the average investor to understand, as a recent ad for an M.S. degree in Financial Mathematics suggests; the program is not offered through the Business School but the Math Department!

2. "Air Products reported $107 million in losses in fiscal 1994 associated with five leveraged interest-rate swaps contracts it entered into with Bankers Trust in 1993." (emphasis added)

My objective here is not to make you experts in these instruments, but to de-mystify some of the vocabulary used.

A "swap," is the exchange of one thing for another. An "interest-rate swap" is a method to manage interest rate risk where parties trade the cash-flows corresponding to different securities without actually exchanging securities directly. The simplest interest-rate swap occurs when one party exchanges a stream of fixed interest payments for a stream of variable payments.

The word "leveraged" typically indicates financing using debt. However, when used in the context of derivatives they indicate a contract that involves the exchange of "multiple" contracts simultaneously. These contracts multiply the risk (i.e., volatility) of a vanilla swap.

The article does not provide more specifics on the contract.

 

By Alex Tajirian

 


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